An Overlooked Bearish Signal That Will Drive 2013

Includes: DIA, GLD, SPY, USO, WMT, XOM
by: Bio Insights

It has been about one week since the Federal Reserve gave the stock market those steroids that it's been craving since the start of the year, and we're already wanting more. An article published today by Louis Woodhill (Forbes) pointed out that the "real" Dow, which divides the index by the spot price of gold (NYSEARCA:GLD), has actually fallen since the announcement. He goes back further in time to point out that the stock market has actually been in utter deterioration by this metric, falling 16% since the start of Obama's administration.

While I do respect gold as the go-to inflation hedge, I'm not so convinced that I'd use gold prices as an accurate tool for examining the deteriorating US economy.

Here's a chart of M2 from the Federal Reserve Bank of St. Louis

M2 has gone up about 200% in the last twenty years, 100% in the last ten years, and about 40% in the last five. If you've ever taken a calculus course, you can note that the slope of the curve is increasing. This is a sign that the growth of M2 is accelerating (the "rate of its growth rate" is going up, which exponentially grows the underlying number in due time).

Let's take a look at gold too.

Spot gold prices, in $/ounce, have gone up almost 400% in the last twenty years (this is not displayed on the 10-yr chart directly above, by the way). In the last ten years, we've seen almost 500% appreciation in the yellow metal and ~200% gains in the last five.

If you double check those figures, you can see that gold actually went through a semi-mild bear market throughout the 90's while the money supply was increasing. In recent years, gold has reversed course completely and has outpaced growth in the money supply by a huge margin. This leads me to question its accuracy as an inverse US dollar "index" of sorts.

Although this statement enrages gold bugs, I maintain that gold too speculative of a commodity these days to measure dollar weakness. If used as a inverse-dollar barometer, the meteoric rise in the price of gold in the last five years implies that greenbacks worth about a third of what they used to be.

This would be a valid statement if crude oil (NYSEARCA:USO) was close to $300/barrel and food prices were roughly tripled, but this simply hasn't been the case. In terms of purchasing power, the dollar has been surprisingly stubborn to let itself slide in worth even as more dollars are being printed under QE3.

This paradox can be largely explained by the bearish signal that is referenced in the title of this article - money velocity.

Money velocity is a measure of the average frequency at which a dollar is used in an economy annually. In simpler terms, it's a way to estimate how many times each $1 is used in a year. Here is what has been happening:

Since the start of the new millennium, money velocity has been declining quite rapidly. The new value of 1.59 is record breaking and gives us a few hints on the situation with the US economy.

If we incorporate trends in wealth distribution in the last two decades (where the rich have been getting richer, and the poor and middle class have been getting poorer), we can infer that there is a lot of cash being "locked up" in banks and bonds. Since it is not being spent, it makes sense that prices have not increased nearly as much as the jumps in aggregate money supply. Basically this means that the economy is not seeing the bulk of those new dollars being put into action.

The US economy, and the dollar, are in tricky territory. We have large reserves of US dollars that could be unleashed on the economy, but we would have to see big jumps in spending by the rich. On the other hand, we could see even lower money velocity in future years, which will not be helped by QE3 and its stimulus to M2 at all.

In either scenario, the stock market is not necessarily going to be the best option for investors. In a strong dollar environment, companies that enjoy the sticky prices. Wal-mart (NYSE:WMT) is one example, because increases in the price of raw inputs will squeeze their profit margins. Commodities producers on the other hand, will suffer. One example would be Exxon-Mobil (NYSE:XOM), which has the highest potential when oil is skyrocketing.

Either way you cut it, we are not in for a smooth recovery. We can either continue our current path of stagnation (or "hidden stagflation"), or see rapid dollar devaluation causing a panic.

Though increasingly speculative, gold is the conventional protection in a hyperinflation scenario. The enormous amount of wealth that is tied up in bonds and other dollar-denominated securities would be in quite a rush to protect against those losses too, which could exacerbate any gold rush.

The broader market (NYSEARCA:DIA)(NYSEARCA:SPY) would probably benefit as well, but due to the negative effects that inflation can have on certain companies it's highly unlikely that we'd see stocks outpace gold, or other commodities.

As we go into 2013, we should be watching money velocity very closely. Not only is it a more direct way to understand our economy's situation, but it will tell us what to expect with regards to future inflation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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